Cap Rate - Do commercial properties have better rates?

Question

When I look at loopnet, I see much better cap rates for commercial properties than for residential properties (analysis done on Zillow, rentometer, etc.) Are commercial properties a better investment in the Triange or NC in general currently?

Salvatore Lentini · Answer

@Asif Aman - Cap Rates are one of many factors to consider when buying commercial real estate.  I use it as a screen.  If a deal is presented to me and it's a 50 unit apartment building in need of a ton of work and it's being sold at a 5 cap based on prop forma numbers.... I don't even look into it any further.  If a deal is presented to me with a Starbucks on the 1st floor and a few apartments above and it's a 5 cap, I will look into it further.  It in no way tells me it's a good deal...it just means it's possible it's a good deal (depends on how many years are left on the lease, how many times they've renewed, if the apartments above have a value-add opportunity, what's going on in that area economically and demographically etc).  I'll also use cap rates to determine my exit strategy... to see what it will be worth if I rehab/reposition the property.  Cap rates vary wildly from area to area and sellers often throw them around with little regard for accuracy.

Daniel Gutierrez · Answer

@Asif Aman Good luck on your search. Don't rush it and stick to the fundamentals. And in regards to the loan and down payment, a residential loan (4 unit or under) will allow a much lower down payment but a commercial loan (5 units or over or a commercial space) will require a commercial loan which is different and often require around 50% down. Make sure you get your financing figured out prior to committing to a commercial property.

Asif Aman · Answer

Thanks everyone for your valuable input. I agree with the larger point that you have to look at many factors, and not just the cap rate, to determine if something is a good investment. I also agree with the specific points that have been made, except for the down payment requirement. We have two banks that are willing to lend us with 25% down.

Maybe I wasn't very clear with my question. I am looking for regular investments; no value add or rehab. And I am looking in A and B class. With those parameters, all other things being equal, I approached a few agents and brokers, and I am presented with deals, residential, that barely cash-flow, however, the commercial ones with much higher cap rates. That's what led to my question.

Daniel Gutierrez · Answer

@Asif Aman I think you may be going about this all wrong. You should know what the cap rate is before you go into escrow. You'll be wasting a lot your time and others if you go into deals not know what you're buying. Your due diligence should be just confirming your original thoughts and calculations; not to believe the seller/ broker and then go into escrow to make sure the numbers are real.

Moreover, investors need to get away from caring so much about the cap rate. There are so many other factors that you should consider when buying an investment property that are just as important or more so than the cap rate. Have you looked at the IRR, GRM, tax implications, etc....? Also, a commercial mortgage normally requires at least 50% down so it takes a very different capital requirement. Lastly, advertised cap rates don't reflect preconceived risk; they reflect what ever BS the seller is trying to get you to believe.

Asif Aman · Answer

Thanks @Daniel Gutierrez . Me and my partners have the 25% down-payment. We have made an offer and are starting the due diligence. If the cap rate turns out to be lower than what the seller told us, we will back out. We will use a management company to manage it and are taking that into account in our calculations.

I wanted to ask others if the higher cap rates (assuming they are correct) are reflecting a greater perceived risk with the commercial.

Daniel Gutierrez · Answer

@Asif Aman you must ALWAYS  do your own analysis. Never blindly believe a brokers "projected" or "actual" proforma. LoopNet has some good raw data but you'll have to do your own analysis to determine what your real cap rate would be. Zillow and Renometer has good for rough estimated but do not tell you how an investment will actually perform. Much of the cap rate is dependent upon your management abilities.

Also, you'll need to consider the differences between a residential property vs a commercial property. They have very different capital requirements and a re two very different types of assets. I'd recommend you determine what you want and then find an investment that meets that. Get creative and don't believe everything you read on LoopNet or Zillow.

Russell Brazil · Answer

There is no such thing as a better or worse cap rate.

Cap Rate - Do commercial properties have better rates?

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